With theincreasing popularity of exchange-traded funds, and passive products ingeneral, many industry observers are beginning to question the demise of activeportfolio management. However, I'd argue that in reality, active managementremains as alive as ever.
Ratherthan outsourcing active management, many investors are taking matters intotheir own hands. Using products like ETFs to under- or overweight certainmarket segments (beta) in an effort to achieve relative outperformance (alpha)is one of the more pronounced trends in the industry today. Although theproducts themselves are passively managed, they are being used tactically in anactive manner by investors seeking to outperform the market.
Developedmarkets, such as the
On thesurface, it would seem that investors are migrating towards passive strategies.Indeed, there are many investors who believe in efficient markets and favorlow-cost indexing as the strategy of choice. However, that doesn't tell thewhole story.
Thereality is that ETFs are tools that advisors and investment managers use tomake active tactical bets. These "bets" can be anything from sectorrotation strategies to underweighting the financials sector or boosting aportfolio's exposure to emerging markets.
While datamay appear to suggest the demise of active management, what I really seehappening is more investors actively managing passive products. Consider thaton any given day ETFs represent 30% to 40% of overall trading volume on the NewYork Stock Exchange. Not exactly the type of activity one would expect frompassive investors.
The death of activemanagement has been greatly exaggerated
As long asa chance for outperformance exists, active management will have prominence inthe investment industry. Human characteristics ensure active management in theinvestment industry is here to stay.
Numerousstudies have examined the role that cognitive behaviour, or human nature, playsin the investment selection process. The universal conclusion is that investorstend to be overconfident in their ability to select winning stocks or funds.
There's acommon example that helps illustrates the tendency of humans to be overlyconfident. A university professor who asks each of his students whether theyare a below average, average, or above average driver will find that roughly90% of the students think they are above average drivers. This, of course, is astatistical impossibility. Similarly, most investors believe they will"beat the market," even though few actually will.
Along withexcessive confidence, there is also an element of hope involved when it comesto investing. In fact, Avi Nachmany, founder of Strategic Insight, notes that"The investment business is, by definition, a business of hope. Everyonehopes that he can beat the market, even if few people actually can."
Active or passive? Both
Unfortunately,the active vs. passive or ETF vs. mutual fund debates tend to be polarizing.But these are not all or nothing proposals. Investors can benefit from keepingan open mind.
In myopinion, a more productive debate would be deciding how much of your optimalportfolio should be in active vs. passive investments, or which asset classeshave the greatest potential for alpha and should therefore be accessed throughactive management.
Aftermaking the philosophical decision to go active or passive in a given marketsegment, the debate should evolve to whether an ETF or mutual fund (or anotherinvestment vehicle) is the best solution for that portion of your portfolio.
In good company
A major trendamong institutional investors in the last several years has been what manydescribe as the "marriage of alpha and beta." Most commonly, thisrefers to an investment strategy that employs passive investments to get corebeta exposure at the lowest possible cost. Recognizing how elusive alpha is inlarge heavily trafficked markets, many professional investors will target assetclasses like domestic large-caps via low-cost passive investments.
With theremaining satellite portion of the portfolio, many institutional investors willlook to access smaller less liquid markets by tapping into the expertise of anactive manager. Active management makes the most sense in markets where theinstitution believes it (or the portfolio manager they plan to hire) has an"edge," or informational advantage.
Investorswould do well by keeping their confidence in check. If you don't have an edge,keep costs low and get passive market exposure. Focus your time and efforts onthe areas of the market where alpha is more abundant and likely to outweigh thehigher costs of active management.
